The goal of fixed income is to achieve a balance between providing the diversification that fixed income offers to riskier parts of a broader portfolio, and being defensive in its own right through low-risk income generation, maintenance of capital stability and high liquidity. Each of these goals is compromised to some degree by low yields. Low yields reduce the degree to which further duration gains can help offset equity losses, income levels are lower, capital stability is threatened as meagre income offers little buffer to (considerable) downside risk to bond prices, while liquidity is diminished as investors are herded into a diminishing pool of positively yielding securities.

Adding to this already considerable challenge for fixed income investors posed by low yields, popular fixed income benchmarks force investors to make a trade-off between the high absolute risks (tied to low yields) embedded in benchmarks and high relative risks of investing away from the benchmark. Managing the balance between the different elements of defensiveness, and between absolute and relative outcomes, is a difficult task.

Outlook and strategy

We have for some time been acknowledging that in spite of structural expensiveness, bonds were unlikely to have a significant cyclically-driven sell-off because of the fragility of the global recovery. Consequently we had been progressively reducing our aggregate short duration position since late 2015. Initially this involved buying back some of our short Treasury position as US rates underperformed into the Fed hike in December. In April and May 2016 we increased our Australian duration on expectation the RBA would ease further following low inflation readings and a strengthening AUD (as central banks elsewhere turned more dovish.

In spite of the ongoing relative short duration position, it’s worth noting that with benchmark duration lengthening materially as the government has both increased and lengthened the maturity of its debt, current absolute duration is close to the longest it’s been since the Strategy’s inception. We hold a long absolute / neutral relative position in Australian duration on our view that cyclical downside risks to the Australian economy will keep easing pressure on the RBA, while our short duration positions remain in the US (on the basis of the relative cyclical strength of the US economy) and in Germany (against negative yields and where valuations appear worst).

Our credit positioning has also moderated. Having added to domestic and global investment grade allocations early in the year as spreads widened, we’ve progressively reduced our exposure since. Our preference has been to reduce global exposure, which we have effectively pared to zero.

While credit is favoured by a continuation of the low-volatility economic environment and by ongoing central bank market participation (which in addition to encouraging buying of riskier assets also dampens volatility), we’re cautious about credit from here owing to concerns about the US credit cycle. With valuations back close to fair value, having been cheap early in the year, we prefer high quality short tenor bonds issued by Australian non-financials, and RMBS.

The cash weighting of the Portfolio has remained elevated at around 20%, both as a function of our relative short duration positioning and our absolute caution on credit. Cash helps keep the portfolio liquid, provides an absolute anchor and affords us flexibility to respond to emerging opportunities.

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Stuart Dear, Deputy Head of Fixed Income, discusses how despite low starting yields and poor valuation support, Australian Fixed Income has returned a healthy 3.6% year-to-date, but notes there are still troubling aspects to performance.

Reasonably rich valuations are preventing significant price appreciation, while at the same time, sensitivity of central banks to financial conditions and market indifference to political developments are limiting the downside.

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